eFinanceManagement.comhttps://efinancemanagement.com
Financial Management Concepts in Layman's TermsTue, 19 Mar 2019 07:25:28 +0000en-UShourly1https://wordpress.org/?v=4.9.9120235918Key Performance Indicators (KPIs) – All You Need To Knowhttps://efinancemanagement.com/financial-analysis/key-performance-indicators-kpis
https://efinancemanagement.com/financial-analysis/key-performance-indicators-kpis#respondTue, 19 Mar 2019 07:25:28 +0000https://efinancemanagement.com/?p=28832Key Performance Indicators or KPI are the quantifiable measures that a company uses to track the performance over time. KPIs measures or demonstrates how effectively the company is achieving its strategic and operational goals. Some examples of KPIs are revenue improvement, cost reduction, customer satisfaction and more. Basically, they track the factors that are important for the success of an organization. They focus on the functions and business processes that the top management sees crucial for achieving the objectives of a business. Key Performance Indicators in Detail A company uses key performance indicators KPIs at multiple levels to track the

]]>Key Performance Indicators or KPI are the quantifiable measures that a company uses to track the performance over time. KPIs measures or demonstrates how effectively the company is achieving its strategic and operational goals. Some examples of KPIs are revenue improvement, cost reduction, customer satisfaction and more.

Basically, they track the factors that are important for the success of an organization. They focus on the functions and business processes that the top management sees crucial for achieving the objectives of a business.

Key Performance Indicators in Detail

A company uses key performance indicators KPIs at multiple levels to track the performance. For instance, a company can use KPIs to track the performance of the sales and also the performance of the employees.

One also uses KPIs to compare the performance of the companies within the same industry. However, KPIs may differ from companies within the same industry as different companies have different business priorities. For instance, for a public company its stock price will likely be its key performance indicator, but for a private company, KPI could be new customers or extra revenue over the last quarter.

Even cut-throat rivals in an industry may focus on a different set of KPIs on the basis of their goals and strategies. Moreover, even within the same company, different people may give importance to different KPIs. For instance, a CEO may give more importance to profit, while head of sales could view additional sales in the quarter as more crucial.

Furthermore, management measures each department on the basis of KPIs specific to that department. Like, sales department will have a different set of KPIs than from the production department.

Below examples will help make KPIs clearer:

A sales team KPIs will be new customers, average deal size, new revenue, total revenue, etc.

A customer support team will track average on-hold time and user feedback.

Importance of KPIs

Helps to keep employee’s focus on the tasks that are critical to achieving the company’s or department’ objective.

KPIs can also give early warnings on potential business issues.

How to Develop KPIs?

To develop key performance indicators a company or an organization must follow the below steps;

Set Goals

A company must first clearly lay down its objectives and goals. These goals must include all aspects of a business, including sales, production, marketing and more.

Track Changes

A business must regularly track the changes in business metrics within a specific time frame. This will help to develop better key performance indicators. Suppose if a business tracks that sales during December usually slows down, then it can come up with a KPI to focus on December sales only.

Identify Critical Success Factors (CSF)

After the goals are set, a company must find out the factors that would help it to achieve the objectives. A point to note is that the CSF must be measurable and specific. For instance, increasing revenue is a vague CSF when compared to setting a goal of increasing sales by $5 million during the third quarter. The latter CSF is clear on the target and the time frame as well.

Use CSFs to create KPIs

KPIs quantify the critical success factors, and thus, help to measure performance. For instance, if the CSF is an aggressive media campaign, then the KPI could be the number of footfalls or number of website views.

Monitor KPIs

To ensure that KPIs remain relevant, business managers must continuously monitor the KPIs. If they feel a KPI is no longer relevant, they should either modify it or remove it.

How to Measure KPIs?

Usually, companies nowadays have systems and tools in place that automatically track the KPIs. These tools collect relevant data and create performance reports as well. This information is then made available to the top management in the form of charts and other data visualizations. This helps the management to get meaningful information and take decision accordingly.

Qualities of a Good KPI

Measurable and quantifiable

Must directly relate to the nature of the business and to the goals and objectives that the company is trying to achieve.

Types of KPIs

Lagging and Leading Indicators

KPI that measure the things that have already occurred –like quarterly profit and revenue growth – are called lagging indicators. On the other hand, KPIs that will tell about future developments – like sales bookings next year – are known as leading indicators.

Quantitative and Qualitative Indicators

Quantitative indicators are the ones that anyone can easily quantify, like new clients. Qualitative indicators are abstract and open to interpretation, like measuring user experience. Finalizing KPIs to measure qualitative indicators is a difficult task and depends on an organization’s ability to identity a way to quantify that qualitative indicator. Like, a number of negative feedbacks can help quantify bad user experience.

Financial and non-Financial KPIs

KPIs that quantify financials like sales, revenue, profit and more are known as Financial KPIs. And, KPIs that do not relate to financials are non-Financial KPIs, like foot traffic, employee turnover, repeat customers and more.

On the Basis of Functional Standpoint

There can be several types of KPIs on the basis of underlying function they measure. Like KPIs for marketing, finance, production, employees, customer satisfaction and more.

Conclusion

Management must communicate the details of the KPIs to the employees at all levels. All employees must know the importance of KPIs and what they help to track. Also, instead of having too many KPIs, management must focus on a small set of important KPIs. This not only saves time and resources, but also helps to focus on key areas.

And, managers must evaluate KPIs from time to time to ensure they are relevant as per changing business needs and are in-line with the company’s goals. If a KPI is found to be not so useful or outdated, it should either be modified or replaced.

]]>https://efinancemanagement.com/financial-analysis/key-performance-indicators-kpis/feed028832Interest Tax Shields – Meaning, Importance And Morehttps://efinancemanagement.com/investment-decisions/interest-tax-shields
https://efinancemanagement.com/investment-decisions/interest-tax-shields#respondSat, 16 Mar 2019 10:48:39 +0000https://efinancemanagement.com/?p=28830Interest tax shields refer to the reduction in the tax liability due to the interest expenses. Companies pay taxes on the income they generate. Interest expenses (via loan and mortgages) are tax deductible, meaning they lower the taxable income. Thus, interest expenses act as a ‘shield’ against the tax obligations. For instance, Suppose Company A has earned a profit before interest and tax of $40000 for a year. If the tax rate is 10%, then the tax liability will be $4000. Assuming Company A also has an interest obligation of $5000, the total taxable income will be $35000 ($40000 –

]]>Interest tax shields refer to the reduction in the tax liability due to the interest expenses. Companies pay taxes on the income they generate. Interest expenses (via loan and mortgages) are tax deductible, meaning they lower the taxable income. Thus, interest expenses act as a ‘shield’ against the tax obligations.

For instance, Suppose Company A has earned a profit before interest and tax of $40000 for a year. If the tax rate is 10%, then the tax liability will be $4000. Assuming Company A also has an interest obligation of $5000, the total taxable income will be $35000 ($40000 – $5000). Now, the tax liability will be $3500. This means the debt obligation helped Company A to save $500 in tax liability.

Motivation to Take More Debt

We can say that the interest tax shields are the tax benefits from the financial structure of a company. For instance, taking a loan rather than issuing equity increases tax shield as interest on loan is tax deductible while dividend paid on equity is not. So, in a way, interest tax shields motivate the companies to take on debt to finance projects rather than using equity.

A point to note is that the interest tax shield is positive when the EBIT (Earnings Before Interest and Taxes) is bigger than the interest expenses.

Tax Shields for Individuals

Interest tax shields are not just available to the corporate. Individuals also can benefit from this. For instance, if they have a home mortgage, they can use the interest payment to create a tax shield. Similarly, interest on Student loan also acts as a tax shield.

One can say that taking on more debt makes you liable to pay regular interest expense, but at the same time, the same interest helps you to lower your tax liability.

Interest Tax Shields – Can Be Risky

Despite the evident benefit of the debt, not many companies prefer this route. One big reason for this is the fear of being unable to meet the interest payments. Another reason is the “covenants” that comes along with the debt.

Covenants are basically the restrictions or the points that a company needs to agree to for obtaining the debt. For instance, a company may have to agree to refrain from a specified action, like not selling assets. Also, certain covenants require the company to maintain certain ratio levels, like Debt Equity ratio or Debt Coverage ratio.

Basically, these covenants are meant to ensure that a company is able to meet its financial obligations. In case, a company is unable to meet these covenants, it may make the debt even more expensive, leading to severe financial pressure on the company.

To recover from such situation, management may refrain from productive investments or even pull money out from current operations to service the debt. This could lower the value of the firm on the basis of future cash generation.

Conclusion

So, before you decide to take on debt for the purpose of benefiting from interest tax shield, it is essential that you understand how it works. Debt is an important part of business valuation, but too much debt may impact future cash flows as well. You must decide to go for the interest tax shields if you are confident on the future cash flows.

Also, the benefits of the interest tax shield depend on the tax rate of the taxpayer. So, understanding current and future macro policies also help you to decide on the debt levels.

]]>https://efinancemanagement.com/investment-decisions/interest-tax-shields/feed028830Default Risk Premium – Meaning, Purpose And Calculationhttps://efinancemanagement.com/investment-decisions/default-risk-premium
https://efinancemanagement.com/investment-decisions/default-risk-premium#respondThu, 14 Mar 2019 09:48:28 +0000https://efinancemanagement.com/?p=28797Default risk premium or (DRP) represent the extra return that the borrower must pay the lender for assuming the extra or default risk. It is commonly used in the case of bonds. DRP compensates the investors or the lender in case the borrower defaults on their debt. Purpose Investors with poor credit record must pay a higher interest rate to borrow money. A lender would charge a higher DRP if they feel borrower have a higher risk of being unable to pay the debt. One can say that the DRP give borrowers a greater incentive not to default on the

]]>Default risk premium or (DRP) represent the extra return that the borrower must pay the lender for assuming the extra or default risk. It is commonly used in the case of bonds. DRP compensates the investors or the lender in case the borrower defaults on their debt.

Purpose

Investors with poor credit record must pay a higher interest rate to borrow money. A lender would charge a higher DRP if they feel borrower have a higher risk of being unable to pay the debt.

One can say that the DRP give borrowers a greater incentive not to default on the debt. Without an adequate DRP, an investor would not invest in companies that have a higher chance of default. By not defaulting on the debt, a company lowers its perceived default risk, and this, in turn, lowers the company’s future cost of raising capital.

Presumably, the government of a country does not pay a default premium. However, in unfavourable conditions, even the government had to pay higher yields to attract investors.

How to Calculate it?

DRP is basically a difference between the risk-free rate and the interest rate charged by the lender. For instance, if a company comes up with a 10-year bond at 6% and the comparable return from a U.S. Treasury bond of a 10-year maturity is 4%, then the DRP is 2%.

There is another more comprehensive way of calculating DRP. An interest rate is made up of several components and DRP is one of those components. So, subtracting all the components (except for DRP) from the interest rate gives the DRP.

Usually, an interest rate is made of following components – risk-free rate, inflation premium, liquidity premium (compensates for investing in less liquid securities like bonds), maturity premium (compensates for investing in securities that will mature many years into the future ) and DRP. So, DRP, in this case, is = Interest rate Less other interest components.

For example, Company A is issuing bonds at 8%. If the risk-free rate is 0.5%, inflation is 2%, liquidity and maturity premiums are both 1% each, then the DRP is (8% – (0.5%+2%1%+1%)) 3.5%.

What Determines Default Risk premium?

Creditworthiness

Usually, companies with lower grade bonds or poor credit rating pay more default premiums. Rating agencies like Moody’s, S&P, and Fitch rate the corporate bonds or companies on the basis of their financial performance. Better financial performance means more safety, and in turn, a higher credit rating.

A higher credit rating would lead to the lower default risk premium, means investors would not get higher returns as the risk is less.

Credit history

If an individual or a company has paid previous debts in time along with the interest payments, it suggests that the entity is trustworthy. Such entities are presumed to have lower default risk, and thus, can borrow money at a lower interest rate. Similarly, the opposite is also true. A person with a poor credit history will have higher default risk and thus, would be a charged a higher DRP.

Liquidity and profitability

This is part of a company’s creditworthiness. Before giving a loan, a bank examines the company’s recent financial statements to determine the company’s profitability. This helps the bank to know if the entity will be able to pay the debt or not. Also, cash flows are examined to determine if the company is generating enough cash to meet the regular interest obligations.

]]>https://efinancemanagement.com/investment-decisions/default-risk-premium/feed028797Leveraged Finance – Meaning, Effects And Morehttps://efinancemanagement.com/sources-of-finance/leveraged-finance
https://efinancemanagement.com/sources-of-finance/leveraged-finance#respondMon, 11 Mar 2019 12:18:14 +0000https://efinancemanagement.com/?p=28799Leveraged finance means giving more debt to a business than what is considered normal for that business. Giving more than the normal debt implies that the debt is riskier, and hence, is costly than the normal debt. Therefore, leveraged finance is primarily used for specific purposes, like repurchase shares, paying a dividend, buying an asset, carry an acquisition and more. So, it basically means acquiring debt to grow the company or increasing an investment’s potential returns. Most businesses prefer such type of financing as it requires little funding on the part of the businesses. But, if the asset for which

]]>Leveraged finance means giving more debt to a business than what is considered normal for that business. Giving more than the normal debt implies that the debt is riskier, and hence, is costly than the normal debt.

Therefore, leveraged finance is primarily used for specific purposes, like repurchase shares, paying a dividend, buying an asset, carry an acquisition and more. So, it basically means acquiring debt to grow the company or increasing an investment’s potential returns.

Most businesses prefer such type of financing as it requires little funding on the part of the businesses. But, if the asset for which the debt was taken did not perform as per the expectations, the same financing becomes a big headache for the business. Irrespective of how asset performs, the interest expense has to paid regularly.

Thus, the bigger the debt amount, the higher is the financial leverage and the higher is the risk.

Who Goes for Leveraged Finance?

To understand who goes for such financing, we need to understand one type of debt. There are two kinds of debt on the basis of debt financing:

Investment-grade debt

Companies with strong credit profile issue such type of debt. Such debt is considered as safe and the default risk is also less.

Speculative-grade debt

Highly leverage companies issue such debt, and thus, it carries a higher risk.

Understandably, leveraged finance focuses on Speculative-grade debt, means companies issuing lower rated debt go for leveraged finance. Specifically, leveraged buyout and private equity firms try to get as much as leverage as possible to boost the internal rate of return or IRR of their investment.

Effects of Leverage

Leverage finance increases the volatility in the earnings and cash flow of a company. As such type of debt financing is costly, the interest payment adds an extra burden on the company’s limited resources

Also, such type of financing increases the risk of lending to the said company. A company that goes for this option is already perceived riskier. And, after availing such financing or debt, the company gets even riskier.

Thus, it is essential for the analysts to understand the use of leverage by a company to accurately create its risk and return profile. Further, understanding the leverage also helps to accurately forecast cash flows

Mezzanine Debt – a Useful Tool

A major tool that comes under the leveraged finance is the mezzanine or “in between” debt. A company uses such debt as an alternative to the high yield bonds or bank debt. Investors in mezzanine debt take on higher risk than the bond investors, but they get higher returns as well. Returns for mezzanine debt investors are somewhat closer to the equity returns.

Traditionally, small companies that were unable to tap the bond market prefer to go for mezzanine debt. Now, companies or investment banks increasingly use such an option as part of a bigger financial package to fund big acquisition deals.

A Specialist Job

Leveraged finance is a specialist job and thus, the investment banking division of a bank has a separate unit, called LevFin or LF, to handle such debt. Such unit is responsible for with offering assistance to the companies who go for leveraged finance. Some of the best names in the LevFin segment are JP Morgan, BAML, Credit Suisse, Citi, Goldman Sachs and more.

]]>https://efinancemanagement.com/sources-of-finance/leveraged-finance/feed028799Top-down Budgeting – Process, Advantages And Disadvantageshttps://efinancemanagement.com/budgeting/top-down-budgeting
https://efinancemanagement.com/budgeting/top-down-budgeting#respondSat, 09 Mar 2019 14:41:53 +0000https://efinancemanagement.com/?p=28828Top-down budgeting is a crucial method of preparing a budget for an organization or a company. Under this method, the senior management prepares a high-level budget on the basis of the company’s objectives. The top management then allocates the amounts for the individual departments, who use those numbers to prepare their own budget. Manager of the individual departments may give suggestions to the top management before the preparation of the budget. But, it is up to the top management to include those suggestions in the budget or not. How a Top-down Budget is Prepared? For the top-down budget, the top

]]>Top-down budgeting is a crucial method of preparing a budget for an organization or a company. Under this method, the senior management prepares a high-level budget on the basis of the company’s objectives. The top management then allocates the amounts for the individual departments, who use those numbers to prepare their own budget.

Manager of the individual departments may give suggestions to the top management before the preparation of the budget. But, it is up to the top management to include those suggestions in the budget or not.

How a Top-down Budget is Prepared?

For the top-down budget, the top management uses past experiences and the current market scenario, including margin pressure, competition, tax legislation, macroeconomic conditions and more.

Also, the management uses past years budget and financial statements as a reference for making an allocation to various departments. Additionally, senior management may also use input from lower-level managers. For instance, if any department accounted for 20% of the overall expenditure last year, then this year it would be allocated 20% of the funds. Any adjustments to these numbers will be based on the input from the managers or the current market scenario.

Process of Top-down Budgeting

The top-level management will meet to decide on the targets for sales, expenses, and profits. Next, the finance department will allocate these targets to other business departments. After this, each department prepares its own budget.

Each department will then come up with a detailed budget, indicating how it will hit the revenue target and at what cost. For instance, the number of products they will sell, how much staff they will need, and more.

All such detailed budgets from the individual departments are then sent back to the finance department. The finance department then approves them if they are in-line with the overall objectives of the company. The finance department may also ask for some revisions if they believe the department’s budget is deviating from the set goals.

After the finance department finalizes all the things, the budgets are put in the system. Going forward, monthly reports are generated to compare the actual results from the planned ones.

Advantages

Such type of budget focuses on the overall growth of the organization.

It makes departments aware of what the top management expects from them.

It is a quick way of preparing a budget and helps to overcome interdepartmental issues.

Saves time for lower management as well. Rather than preparing the budget from scratch, each department gets a set goal. This saves both time and resources.

Under top-down budgeting, management creates only one budget, rather than allowing the department to create their own budget and combine them later. Hence, it is a less tedious approach.

Disadvantages

Since managers are not part of the budget-making process, they may not feel much motivation to ensure their success.

Since senior managers are not much aware of the day-to-day operations of the departments, they may set unrealistic targets. This results in lower-level managers finding it difficult to meet the set numbers.

Such type of budgeting may often lead to over or under allocation of resources.

Bottom-up Budgeting

Bottom-up budgeting is also a type of budgeting, but it’s the exact opposite of the top-down budgeting. The bottom-up budgeting starts at the department level and then moves up to the top management.

Under this, the departmental heads or managers create their own budget and then submit it to the top management. They prepare the budget on the basis of present information and past experiences. Also, manages to give a proper explanation for each item in the budget. The top management approves, revises or sends it back for modifications. After top management approves all the department budgets, it comes up with a master budget.

Conclusion

Whether you should go for top-down budgeting depends on the size and structure of your business. For a smaller business with not many departments, a top-down approach is preferable as there won’t be a large disconnect between the upper and the lower-level managers. But, as your company starts to grow, it will be better to get more inputs from the managers of the departments.

]]>https://efinancemanagement.com/budgeting/top-down-budgeting/feed028828Capital Budgeting Techniques With an Examplehttps://efinancemanagement.com/financial-management/capital-budgeting-techniques-with-an-example
https://efinancemanagement.com/financial-management/capital-budgeting-techniques-with-an-example#respondFri, 08 Mar 2019 10:36:09 +0000https://efinancemanagement.com/?p=28789Capital Budgeting Techniques We have already discussed the importance of capital budgeting. It is a process that helps in planning the investment projects of an organization in long run. Let’s understand all the following capital budgeting techniques with an example. i) Payback period ii) Discounted payback period iii) Net present value iv) Accounting rate of return v) Internal rate of return vi) Profitability index Example of Capital Budgeting ABC Inc. is planning to buy machine A which will cost $ 10 million. The expected life of the machine is 5 years. The salvage value of the machine is nil. ABC

We have already discussed the importance of capital budgeting. It is a process that helps in planning the investment projects of an organization in long run. Let’s understand all the following capital budgeting techniques with an example.

i) Payback period

ii) Discounted payback period

iii) Net present value

iv) Accounting rate of return

v) Internal rate of return

vi) Profitability index

Example of Capital Budgeting

ABC Inc. is planning to buy machine A which will cost $ 10 million. The expected life of the machine is 5 years. The salvage value of the machine is nil. ABC Inc. is expecting cash-flow of $ 5 million for the first two years, $ 3 million for the next 2 years & $ 2 million in 5th year. Operating expense is $ 1 million for every year. Discounting rate is 10%. (Assumption: No tax)

Now let’s find out the answer by using different techniques.

i) Payback period

Payback method is used to know how much time it will take to recover the investment.

(Amount in Millions)

Year

Revenue

Operating cost

Profit

Cumulative Profit

1

$ 5

$ 1

$ 4

$ 4

2

$ 5

$ 1

$ 4

$ 8

3

$ 3

$ 1

$ 2

$ 10

4

$ 3

$ 1

$ 2

$ 12

5

$ 2

$ 1

$ 1

$ 13

Here we can see it take 3 years to generate sufficient profit to recover the cost. So the payback period is 3 years.

ii) Discounted payback period

This method is the same as the payback period method. The only difference in payback period & discounted payback period is, it considers the discounted cash flow for finding payback period.

iii) Net Present Value

NPV is one of the most commonly used methods for investment appraisal techniques. It is the sum of all future discounted cash-flow less initial investment. If the amount is positive then the project should be accepted otherwise it should be rejected.

In discounting payback period we can see the sum of all future discounted cash-flow is $ 10.4315 million & initial investment is $ 10 million. It means NPV is $ 0.4315 million. It is positive, hence the project should be accepted.

iv) Accounting Rate of Return

Accounting rate of return is also known as return on investment or return on capital. It is an accounting technique to measure profit expected from an investment.

v) Internal Rate of Return

Internal Rate of Return is the discounting rate used for investment appraisal, which brings the cost of the project & its future cash flow at par with the initial investment. It is obtained by trial & error method. We already have discounted value at 10% discounting rate.

]]>https://efinancemanagement.com/financial-management/capital-budgeting-techniques-with-an-example/feed028789Public Financehttps://efinancemanagement.com/financial-management/public-finance
https://efinancemanagement.com/financial-management/public-finance#respondThu, 07 Mar 2019 06:30:46 +0000https://efinancemanagement.com/?p=28837What is Public Finance? In simple layman terms, public finance is the study of finance related to government entities. It revolves around the role of government income and expenditure in the economy. Prof. Dalton in his book Principles of Public Finance states that “Public Finance is concerned with income and expenditure of public authorities and with the adjustment of one to the other” By this definition, we can understand that public finance deals with income and expenditure of government entity at any level be it central, state or local. However in the modern day context, public finance has a wider

In simple layman terms, public finance is the study of finance related to government entities. It revolves around the role of government income and expenditure in the economy.

Prof. Dalton in his book Principles of Public Finance states that “Public Finance is concerned with income and expenditure of public authorities and with the adjustment of one to the other”

By this definition, we can understand that public finance deals with income and expenditure of government entity at any level be it central, state or local. However in the modern day context, public finance has a wider scope – it studies the impact of government policies on the economy.

Let’s understand the scope of public finance to understand how public finance impacts the economy.

The scope of Public Finance

Prof. Dalton classifies the scope of public finance into four areas as follows –

Public Income

As the name suggests, public income refers to the income of the government. The government earns income in two ways – tax income and non-tax income. Tax income is easy to recognize, it’s the tax paid by people of the country in the form of income tax, sales tax, duties, etc. On the other hand non-tax income includes interest income from lending money to other countries, rent & income from government properties, donations from world organizations, etc.

This area studies methods of taxation, revenue classification, methods of increasing government revenue and its impact on the economy as a whole, etc.

Public Expenditure

Public expenditure is the money spent by government entities. Logically, the government is going to spend money on infrastructure, defense, education, healthcare, etc. for the growth and welfare of the country.

This area studies the objectives and classification of public expenditure, effects of expenditure in different areas, effects of public expenditure on various factors such as employment, production, growth, etc.

Public Debt

When public expenditure exceeds public income, the gap is filled by borrowing money from the public, or from other countries or world organizations such as The World Bank. These borrowed funds are public debt.

This area of public finance explains the burden of public debt, why it is necessary and its effect on the economy. It also suggests methods to manage public debt.

Financial Administration

As the name suggests this area of public finance is all about the administration of all public finance i.e. public income, public expenditure, and public debt. Financial administration includes preparation, passing, and implementation of government budget and various government policies. It also studies the policy impact on the social-economic environment, inter-governmental relationships, foreign relationships, etc.

Functions of Public Finance

There are three main functions of public finance as follows –

The Allocation Function

There are two types of goods in an economy – private goods and public goods. Private goods have a kind of exclusivity to themselves. Only those who pay for these goods can get the benefit of such goods, for example – a car. In contrast, public goods are non-exclusive. Everyone, regardless of paying or not, can benefit from public goods, for example – a road.

The allocation function deals with the allocation of such public goods. The government has to perform various functions such as maintaining law and order, defense against foreign attacks, providing healthcare and education, building infrastructure, etc. The list is endless. The performance of these functions requires large scale expenditure, and it is important to allocate the expenditure efficiently. The allocation function studies how to allocate public expenditure most efficiently to reap maximum benefits with the available public wealth.

The Distribution Function

There are large disparities of income and wealth in every country in the world. These income inequalities plague society and increase the crime rate of the country. The distribution function of public finance is to lessen these inequalities as much as possible through redistribution of income and wealth.

In public finance, primarily three measures are outlined to achieve this target –

A tax-transfer scheme or using progressive taxing, i.e. in simpler words charging higher tax from the rich and giving subsidies to the low-income

Progressive taxes can be used to finance public services such as affordable housing, health care, etc.

A higher tax can be applied to luxury goods or goods that are purchased by the high-income group, for example, higher taxes on luxury cars.

The Stabilization Function

Every economy goes through periods of booms and depression. It’s the most normal and common business cycles that lead to this scenario. However, these periods cause instability in the economy. The objective of the stabilization function is to eliminate or at least reduce these business fluctuations and its impact on the economy. Policies such as deficit budgeting during the time of depression and surplus budgeting during the time of boom helps achieve the required economic stability.

Now that we understand the study of public finance, we must look into its practical applications. So let us understand the career opportunities in public finance –

Career Opportunities in Public Finance

Investment Banking

An investment banking career in public finance domain entails raising funds for the development of public projects. Investment bankers help government entities in the following three areas –

Analyzing project finance opportunities for large government projects and raising debt and equity funds for such projects.

Advising government companies on mergers and acquisitions, divestments, etc.

Research

This is a fairly large area of public finance careers, and a lot of public finance professionals eventually become researchers. Many large banks, government entities, and world organizations require public finance professionals to consolidate necessary data points for decision making. Thus there is a regular requirement of public finance professionals in the field of research.

Academia

A lot of public finance professionals eventually go on to become professors and teach public finance in universities and colleges. Not only limited to teaching, but they also participate in university researches to improve understanding of the field and create new tools for efficient practical applications.

]]>https://efinancemanagement.com/financial-management/public-finance/feed028837Bullish And Bearish – Meaning, Relevance And Morehttps://efinancemanagement.com/derivatives/bullish-and-bearish
https://efinancemanagement.com/derivatives/bullish-and-bearish#respondMon, 04 Mar 2019 09:53:57 +0000https://efinancemanagement.com/?p=28809The term bullish and bearish describes the condition in the market or the sentiment of the investors or a general market trend. Both bullish and bearish are the antonym of each other. If a market is in a long-term uptrend, it is called a bull market, and if the market is in a long-term downtrend or the prices are falling continuously, it is called a bear market. For instance, you must have heard a trader or analyst say that “I am bullish on Company A.” This means, that the trader or analyst expects the stock price of the said company

]]>The term bullish and bearish describes the condition in the market or the sentiment of the investors or a general market trend. Both bullish and bearish are the antonym of each other. If a market is in a long-term uptrend, it is called a bull market, and if the market is in a long-term downtrend or the prices are falling continuously, it is called a bear market.

For instance, you must have heard a trader or analyst say that “I am bullish on Company A.” This means, that the trader or analyst expects the stock price of the said company to go up.

A Bullish Mindset

Bullishness is a mindset or sentiment when a trader feels the price of a security will move up. Usually, if a market recovers 20% or more from the bottom, then it is in a bullish phase. The term ‘bull’ as the name suggests, is inspired by the bull, who hits upwards with the horns. And, that is why it represents prices going up.

A Bearish Mindset

Bearishness is the sentiment that the securities and markets will go down or is moving down. The term ‘bear’ or ‘bearish’ as the name suggests comes from a bear, who hits downward with its pawns. Bears usually represent sellers in the market. They resort to selling as they believe things will get worse. Similar to the bull phase, a market or security enters the bear phase if it drops more than 20%.

Bullish and Bearish – How They are Used?

A point to note is that term bullish and bearish describes both the sentiment and trend towards a specific stock and also the whole market. For example, if a trader says that he is bearish on the stock market, it means he expect the market to drop. A trader may have his or her own bullish and bearish sentiment. But, if the majority of traders have the same sentiment, then it will lead a market into a downtrend or long-term up.

One can use both the terms to talk about the future and also the current trend. For example, one can say that the market is in a bullish phase, meaning the market is dropping. On the other hand, if one says that the market will have a bull run in summer, it will mean the future expectations.

Also, both bullish and bearish sentiment and predictions are backed by reasons. For instance, if a trader says that he is bullish on Apple after Q3 earnings, it means that the company will announce upbeat Q3 earnings, which will push the stock prices up.

A trader can be both bullish long-term and bearish short-term both on a specific stock and the market. For example, a new tax reform may push the market down initially, but in the long-term, it could push the market up.

Both these terms are commonly used in the stock market, but their use is not limited to stocks. One can use them to represent the trend in any financial market, including real-estate, commodities and more.

If a trader is bullish on the market, it does not mean that the price of all the securities will go up. Similar is the case with the bear phase as well.

Usually, a bullish market follows an economic expansion and bear market follows a recession. However, it is not always the case. A market can have a bull run without economic expansion or a bull market without a recession. Sometimes, a bull market follows a bear market, and vice versa.

How They can Help Traders?

Knowledge of bullish and bearish markets conditions could help traders make profits easily. A sufficient knowledge of these terms help traders identify bull and bear cycles beforehand, thus, take positions accordingly.

Traders can make profits in both bearish and bullish cycles. If a trader expects a bull, then he can buy the security or hold onto it for more time. And, if a trader expects the prices to drop, then he can sell the securities now to avoid losses. They can also short the stock if they expect the price to drop.

Conclusion

Every trader must know and understand both these terms clearly as they are frequently used in the financial markets. Also, these terms help understand the market more clearly and make profits irrespective of you being a day trader or a long-term investor.

]]>https://efinancemanagement.com/derivatives/bullish-and-bearish/feed028809Times Interest Earned – Formula, Advantages, Limitationshttps://efinancemanagement.com/financial-analysis/times-interest-earned
https://efinancemanagement.com/financial-analysis/times-interest-earned#respondWed, 27 Feb 2019 14:18:39 +0000https://efinancemanagement.com/?p=28741Times interest earned or (TIE) is a metric that helps to measure a company’s ability to meet the interest payments on its debt. To calculate TIE or interest coverage ratio we use earnings before interest and taxes (EBIT) and the total interest payable, including on bonds and other debts. TIE indicates whether or not the company earns enough to cover its interest charges. It is mostly used by lenders to ascertain if a prospective borrower can be given a loan or not. Times interest earned is also considered by many to be a solvency ratio as it tells the ability

]]>Times interest earned or (TIE) is a metric that helps to measure a company’s ability to meet the interest payments on its debt. To calculate TIE or interest coverage ratio we use earnings before interest and taxes (EBIT) and the total interest payable, including on bonds and other debts.

TIE indicates whether or not the company earns enough to cover its interest charges. It is mostly used by lenders to ascertain if a prospective borrower can be given a loan or not.

Times interest earned is also considered by many to be a solvency ratio as it tells the ability of a firm to meet its interest and debt obligations. And, since the interest payments are for a long-term basis, the interest expenses are a fixed expense. If a company is unable to meet its interest expense, it may go bankrupt. And, this is why TIE is seen as a solvency ratio.

TIE Formula

Let’s understand TIE with the help of an example. Suppose a business has an EBIT of $100000 and interest payable on the loan is $25000. In this case, TIE will be 4 ($100000/$25000). This means the company earns four times the money that it needs to pay as interest.

Higher TIE is good both for the lenders and borrowers. But, a usually big TIE could also mean that the company is “too safe” and is missing on productive opportunities. On the other hand, a TIE of lower than one means the company may not have sufficient funds to meet the debt obligation.

To know if the TIE of a company is “safe” or “too face” or “low” one must compare it with the companies operating in the same industry.

Advantages

It is easy to calculate.

The ratio indicates the solvency of a company.

It can help to compare the two companies.

Negative ratio means the company is not financially sound.

Limitations

Using EBIT to calculate TIE does not give a clear picture. EBIT does not actually mean the cash generated by the business. It is possible that much of the sales of business are on a credit basis. On the other hand, it may also happen that the ratio may come low even if the business has significant positive cash flows.

The interest expense figure is also an accounting calculation and may not reflect the actual interest expenses. For instance, it may include discount or premium on the sale of bonds. To avoid this, one should calculate the interest using the rate given on the face of the bonds.

The metric does not take into account any upcoming principal payment. TIE may show a favorable number even if the business is facing a principal payment that is big enough to eat up all EBIT.

It primarily focuses on the company’s short-term ability to meet the interest payment as it is based on the current earnings and expenses

How to Overcome Limitations?

In place of EBIT, one may use EBITDA (earnings before interest, taxes, depreciation, and amortization) to get the real cash position. Depreciation and amortization are non-cash expenses, and thus, they don’t have any impact on the cash position.

To get an even clearer picture, we could also use Times Interest Earned (Cash Basis) (TIE-CB). It is similar to the normal TIE, except that TIE-CB uses adjusted operating cash flow instead of EBIT. The ratio is calculated on a “cash basis” as it considers the actual cash that a business has to meet its debt obligations.

Also, an analyst should prepare a time series of the TIE to get a better understanding of the company’s financial standing. A single TIE may not be much useful as it would include onetime revenue and earnings. So, calculating TIE regularly would give a better picture of a firm’s financial standing.

]]>https://efinancemanagement.com/financial-analysis/times-interest-earned/feed028741Revenue Run Rate – Meaning, Importance & Limitationshttps://efinancemanagement.com/financial-management/revenue-run-rate
https://efinancemanagement.com/financial-management/revenue-run-rate#respondTue, 26 Feb 2019 14:32:50 +0000https://efinancemanagement.com/?p=28766Revenue run rate is a concept that takes the company’s current revenue to predict future revenue. Basically, it takes the current revenue of a company for a week, month, quarter or yearly and converts it into an annual figure for the next year. The concept simply extrapolates or extends the current financial number over a year. For instance, if a business makes $1 million revenue in the first month of the year, then on the basis of revenue run rate, the company will make $12 million in the full year. Revenue run rate is also called Sales Run Rate and

]]>Revenue run rate is a concept that takes the company’s current revenue to predict future revenue. Basically, it takes the current revenue of a company for a week, month, quarter or yearly and converts it into an annual figure for the next year. The concept simply extrapolates or extends the current financial number over a year.

For instance, if a business makes $1 million revenue in the first month of the year, then on the basis of revenue run rate, the company will make $12 million in the full year.

Revenue run rate is also called Sales Run Rate and is primarily used by rapidly growing companies. The concept assumes that the present financial environment won’t change much in the future.

Formula & Uses

To calculate the run rate, divide the year-to-date sales by the sales periods to date. And, multiply the result with the remaining sales period.

Along with the companies witnessing rapid growth, this concept of predicting revenue is useful for startups or a new unit within the company. The concept also helps investors, venture capitalists and managers to predict the annualized revenue.

Additionally, the run rate concept is useful in several situations:

When a business is attempting to sell itself, it will extrapolate its revenue to get more price.

Management team may use the revenue run rate for the budgeting

A business may also use the concept to extrapolate the profits when it has incurred losses in the earlier periods. Usually, such a strategy is adopted by startups.

Such a concept is also useful when a business witnesses any change in its fundamental business operation in the midway. Suppose after intense cost-cutting, a business is able to increase its quarterly profits by five times. In such a case, the run rate is a better indicator of the firm’s profitability than the previous year results.

Limitations

Unreal Assumptions

The run rate concept assumes that the current financial condition of business will continue in the future year as well. This assumption is unreal as businesses nowadays face changing business scenarios.

One Time Sales

Businesses have customers whose contracts expire after a set time. If sales from these clients expire in the extrapolated period, it would unnecessarily boost the forecasted revenue.

Seasonality

If sales of a company are seasonal, then the annual revenue run rate on the basis on peak season would not be achievable. To overcome this, a business must calculate the run rate on the basis of a full year to factor the full season effect.

Capacity Constraints

There are chances that a business used massive capacity utilization in a period. And, if that same period is used for revenue run rate, it would give a wrong picture as a business may not be able to direct the same resources again.

Encourage Cheating Habits

A business may also use this concept to fool investors. What they can do is use the month with very high sales as a base to calculate future revenue.

How to Overcome these Limitations?

Historical Trends

Usually, a company has comparatively better sales in some months and worst in others. So, one must identify those months and take an average of those. This will give a more realistic picture.

Know your Customers

Understanding the customer’s buying pattern, preferences and behavior also help to get a better run rate. To get an accurate picture, one must consider patterns and deviations from the customer’s behavior. For instance, a manager must know how many repeat and one-time customers they have, what products are the following, and more.

Events that Impact Revenue

Events like elections, sports event or a religious event may affect sales of a business. So, one must keep a record when there is an increase or decrease in sales due to any event. It will be better not to include such sales for calculating the run rate.

Monitor Competitors

Keeping a close watch on the rivals will help you adjust your prices and strategies accordingly. Eventually, this will help get a better run rate.

Capacity Utilization

It is normal for a business to operate at full or over capacity during a particular period. Then to make up for that a business needs to slow down. So, neglecting such periods will help you get a better run rate.

Bottom Line

Revenue run rate is a useful metric, but it can give unreal numbers under some scenarios. So, using it carefully and normalizing the effect of uneven numbers will help get a real financial picture.